Municipalities in general have debt structures that may rely exclusively or predominantly on fixed rate debt (such as “credits” in the form of loans, bonds, or other obligations). Some of the reasons may include the following:                a) Fixed rated debt is accepted and municipal debt managers do not have to justify their decision to use it, even if it imposes an additional cost on the municipality (the additional cost may be in essence the cost of interest rate insurance against the possibility that increasing interest rates may cause the cost of variable rate debt in the future to exceed the cost that can be locked in with fixed rate debt).        b) Interest rates may vary significantly within a budget period.        c) A debt manager may face political risk by issuing variable rate debt. The political risk to the debt manager if he or she elects to issue variable rate debt is not just that the present value cost of variable rate debt may exceed the cost of fixed rated debt over the term of the debt, but also includes the possible risk of being criticized if rates spike in a particular year or group of years, even if the savings in prior years were significant and there were net savings overall (in some cases there may not even be legislative authority to issue variable rate debt, ostensibly due to the interest rate risk associated with such debt).        d) Budgeting planned by a current debt manager may not be carried through in later years by subsequent debt managers and/or political decision makers (thus increasing future interest rate risk).        
In issuing such traditional fixed rate debt (e.g., traditional municipal fixed rate bonds), a municipality pays its fixed rate bondholders a higher interest rate (versus non-fixed rate debt) to accept all of the risks and benefits of ownership of the municipal debt. In essence, the municipality purchases insurance against these risks from its fixed rate bondholders. The compensation to the fixed rate bondholders is both the higher fixed rate and the potential benefits associated with ownership of the debt.
On the other hand, when a municipality does utilize variable rate debt the changes over time in a municipality's variable interest rate generally occur because the issuer retains a variety of risks and benefits associated with ownership of municipal debt that, in the context of fixed rate debt, are transferred to the fixed rate bondholders. Thus, the issuer must generally revise the interest rate on its variable rate debt to reflect both favorable and unfavorable changes in market conditions that affect the value of ownership of the debt in order to keep the value of the debt essentially equal to par. The value of such traditional variable rate debt must be maintained essentially at par to motivate the current debt holder to retain its ownership or to enable the debt to be remarketed to a new holder if the debt is put back to the issuer by the current debt holder.
In any case, as seen in Table 1, a number of representative characteristics that generally affect the value of ownership of municipal debt (and the associated risks and benefits of ownership) include:
TABLE 1CharacteristicRiskBenefitGeneral level of Increasing ratesDecreasing ratesinterest ratesExemption from Decrease in marginal tax Tax increasestate/federal taxrate or repeal of exemptionCredit of issuerImprovement in creditCredit deteriorationCredit of credit Improvement in creditCredit deteriorationenhancerCredit of liquidityImprovement in creditCredit deteriorationproviderSupply and demand Increase in supply or Decrease in supply for municipal bondsdecrease in demandor increase in demand
As noted above, by issuing traditional fixed rate debt, an issuer essentially fully hedges each of the above characteristics (i.e., the issuer fixes both the cost and the benefit derived from the issuance of the debt). In contrast, by issuing traditional variable rate debt, the issuer retains both the risk and benefit associated with each ownership value characteristic. Given a specific bond interest rate, adverse changes with respect to any ownership value characteristic would cause a decline in the value of the bond and positive changes would cause an increase in the value of the bond. Thus, the issuer must increase the bond interest rate to compensate for adverse changes in order to be able to remarket its bonds. On the other hand, positive changes allow the issuer to decrease its bond interest rate while still being able to remarket its bonds.
Finally, it is noted that fixed-payer interest rate swaps (in which the issuer makes a fixed rate payment and receives a variable rate payment that offsets the interest payable on the issuer's variable rate bonds) are used to create fixed rate debt “synthetically” by fully or partially hedging the risks of debt ownership. As seen in Table 2, the extent to which such risks are hedged is determined by the methodology used to calculate the variable rate swap payment received by the issuer:
TABLE 2Variable swap paymentRisks hedgedRisks Not HedgedIssuer's actual bond Interest ratesNoneinterest rateFederal and state taxesIssuer creditCredit enhancer and liquidity provider creditMunicipal supply and demandBond Market Association Interest ratesState taxes(BMA) rateFederal taxesIssuer creditMunicipal supply Credit enhancer and and demandliquidity provider creditBMA rate with a taxInterest ratesState taxesflip to a percentage of Partial hedge of Issuer creditLIBOR upon certain federal tax riskCredit enhancer and events involving Municipal supply liquidity provider creditsignificant and demandFederal tax risk not changes in the value of fully hedgedfederal tax exemptionFixed percentage Interest rate riskFederal and state taxesof LIBORIssuer creditCredit enhancer and liquidity provider creditMunicipal supply and demand
Of note is the fact that the risk of a deviation between the interest rate on an issuer's variable rate bonds and the variable payment received by the issuer on a fixed-payer swap is referred to as “basis risk”. Basis risk exists to some degree on any swap on which the payment received is not calculated using the issuer's actual interest rate.
Nevertheless, neither such traditional fixed rate debt, nor such traditional variable rate demand debt, nor such traditional fixed-payer interest rate swaps necessarily provides for the management of debt in a manner desired by the debt issuer.
Among those benefits and improvements that have been disclosed, other objects and advantages of this invention will become apparent from the following description taken in conjunction with the accompanying figures. The figures constitute a part of this specification and include exemplary embodiments of the present invention and illustrate various objects and features thereof.